Today's inflation figures are shocking but should not have come as a complete surprise given recent warning signals. The details show few redeeming features. Eight of the 11 main categories contributed to the increase in the annual headline rate. The only significant negative contributions were from clothing/footwear and transport – the latter mainly reflecting an erratic fall in air fares.

My previous forecast was that inflation would reach the 3.1% letter-writing level in July, peaking at 3.5% in September and remaining above 3% until February 2009. This was at the top end of economists' expectations but now looks too low. A 4% peak now looks plausible if retail energy prices are hiked by a further 20% later this year, as widely expected.

The view that the Bank of England’s Monetary Policy Committee should continue to cut interest rates because a weakening economy will ensure inflation is back below target in two years’ time is questionable, to say the least. For one thing, the MPC’s remit is to hit the target “at all times” – its actions have less effect at short horizons but still have some impact, so it is wrong to focus solely on the two-year-ahead forecast. More importantly, a nonchalant MPC response to a significant and prolonged overshoot risks undermining its inflation-fighting credibility. Inflation expectations are already showing signs of detaching from the target; if firms and workers build a higher trend level of inflation into price- and wage-setting behaviour, the forecast return to 2% or lower two years ahead is unlikely to occur.

In the last Reuters interest rate poll, conducted before the May MPC meeting, New Star was one of only three houses expecting Bank rate to be held at 5.0% for the remainder of 2008. A near-term cut now looks extremely unlikely barring recessionary signals from activity data.

Recent posts have warned that a surprising surge in inflation could put paid to hopes of early further interest rate cuts. A “triple whammy” of bad news this morning suggests this risk may be crystallising:

1. Factory-gate prices jumped 1.4% in April to stand 7.5% higher than a year ago – the largest annual increase since 1985. The “core” annual rise – excluding food, beverages, tobacco and petroleum products – was 4.6%, a 13-year high.

2. Import prices surged a further 1.9% in March, pushing their annual increase up to 10.3% – approaching the peak of 13.7% reached in 1993 following sterling’s expulsion from the ERM. With the effective exchange rate down by 2% since March and world prices of imported commodities continuing to climb, a further rise is certain.

3. Energy supplier Centrica announced a fall in margins in its residential business to below long run target levels, despite price increases in January. It warned that it would “take the necessary action to deliver reasonable margins in the retail business”, supporting forecasts that residential tariffs will rise by at least a further 10% later in 2008.

New projections in Wednesday’s Inflation Report may show annual CPI inflation peaking at close to 4% later this year and remaining at or above the 3.1% letter-writing threshold for six months or more (see here).

While surging world commodity prices have been the key factor driving inflation higher, the impact has been magnified by a 13% fall in the effective exchange rate from a peak last July – equivalent in magnitude to the 1967 devaluation, when Harold Wilson famously claimed “the pound in your pocket” would be unaffected. Many economists have cheered on this decline, arguing it was necessary to “rebalance” the economy away from consumer spending. In a speech in January, Mervyn King talked approvingly of a drop of almost 10% in the effective rate by then, adding helpfully that “ financial markets are pricing in a significant probability of a further decline”.

With the broad money supply M4 having risen 22% more than nominal GDP over the last three years, and the exchange rate sharply weaker, the surprise is that economists should be surprised by current inflationary problems.

My current projection shows annual consumer price inflation above 3% between July 2008 and January 2009, peaking at 3.5% in September. This is based partly on an assumed further 10% rise in household electricity and gas tariffs. Recent press reports have, however, suggested a much larger rise in retail energy prices.

The chart below shows the CPI component covering “electricity, gas and miscellaneous energy” together with 12-month moving averages of wholesale natural gas and oil prices. The averages remove volatility and seasonal influences and are a reasonable guide to the trend in suppliers' purchasing costs. They have been projected forward assuming prices remain at current seasonally-adjusted levels.

The moving averages peaked in mid 2006 and fell significantly to a trough in the third quarter of 2007. Household tariffs followed, topping in February 2007 and reaching a low last October. Wholesale gas and oil prices have since surged: if current levels are sustained the 12-month moving averages will be 50-60% above their 2006 peaks by early 2009.

The CPI component rose by 11.9% between October and March but is only 1.9% above its February 2007 peak. Recent experience suggests pass-through from wholesale to retail prices of between a quarter and a half. This suggests a further rise in household tariffs of between 10% and 25% will be needed if current wholesale prices are sustained.

A rise of 25% rather than 10% in retail energy prices would result in a mechanical boost of 0.5 percentage points to annual CPI inflation in late 2008 and early 2009. The actual impact would be smaller because the implied squeeze on consumer spending would slow price rises for other goods and services. Even so, the scenario could involve headline inflation peaking at close to 4% and remaining above 3% for as long as nine months, necessitating three explanatory letters.

I am sticking with a 10% figure for the moment, partly on the view that current wholesale prices may not be sustained. Next week’s May Inflation Report will reveal the assumption used by the MPC. Inflation projections could be revised up by more than the market expects, raising doubts about the scope for interest rate cuts.

Earlier in the year I suggested the ECB would be in a position to cut rates by May (for example here). While the economy has slowed as expected, the forecast has been undermined by a further rise in headline inflation, mainly due to soaring food and energy prices.

My ECB-ometer forecasts an “average interest rate recommendation” of the 21 Governing Council members of -0.01% at this week’s meeting. This is well above the -0.125% threshold for a cut and up from -0.05% in April. The increase over the last month reflects a fall in the euro and improved credit market conditions, which have offset further weakness in business surveys and a slowdown in money supply growth.

The chart presents the ECB-ometer’s output in terms of the probability of a rate change. (Previous posts have shown the average interest rate recommendation.) The chances of a rate cut are estimated to have fallen from 40% in March to below 10% this month.

While the model has become less dovish, it continues to suggest a slight easing bias is warranted by incoming data. This is at odds with the policy statement issued after last month’s meeting and raises the possibility that ECB President Trichet will be less hawkish in his remarks tomorrow.

Activity data should deteriorate further over coming months but recent energy price strength will delay a retreat in headline inflation. I am pencilling in a rate cut in the third quarter but it currently looks far from certain.

This week's MPC rate decision is a particularly difficult call. Activity indicators are at levels historically consistent with a quarter- or even half-point Bank rate cut. The near-term inflation outlook remains troubling, however, with the May Inflation Report likely to show a larger and more prolonged overshoot than projected in February. (Commentators often seem to forget that the Committee’s remit is to achieve 2% inflation “at all times”.) Meanwhile, financial markets have calmed significantly and MPC members hope the new Special Liquidity Scheme will contribute to further improvement.

Weighing up these factors, my MPC-ometer suggests a 6-3 vote for unchanged rates this week. A cut is certainly possible but would be dangerous given current inflationary risks. For comparison, the model forecast is close to the 5-4 vote for no change by the Sunday Times Shadow MPC.

With this week’s further cut, the Federal Reserve has brought its target Fed funds rate below the annual increase in the “core” personal consumption price index (2.0% versus 2.1%). Historically, this measure of real interest rates has become negative only well into or after recessions – see first chart. Indeed, in two cases – the 1980 and 1981-82 recessions – real rates troughed above zero.

With the advance first-quarter GDP estimate suggesting marginal growth (0.6% annualised), a recession has yet to be confirmed – see also here. Intrade’s recession contract now implies a 33% probability of two consecutive negative GDP quarters in 2008, down from a recent peak of 79%.

The Fed normally requires evidence of significant economic slack before easing policy aggressively. Both the unemployment rate and industrial capacity utilisation are currently little different from their averages over the last five years.

A useful survey-based measure of industrial capacity pressures is the ISM manufacturing “supplier deliveries” index, based on the number of purchasing managers reporting longer delays in obtaining production inputs. An index level of 52 has historically separated periods of Fed easing and tightening – see second chart.

The index was modestly below 52 between February and November last year, signalling rate cuts, although not to the extent actually delivered. It has recovered more recently, reaching a 20-month high of 54 in the April survey released yesterday.

The current divergence between capacity use indicators and the level of real interest rates is unsustainable. Unless capacity pressures ease significantly, the Fed may be forced to consider reversing recent cuts later in 2008.